More OZ Guidance Needed for Operating Business Investments to Take Off

While the opportunity zones (OZ) incentive is still in its infancy, investments in real estate are starting to take off.

However, many believe that investment in operating businesses is what will make this incentive the most impactful community development tool.

“This incentive is the brainchild of the folks at Economic Innovation Group [EIG]. They envisioned the incentive as an economic engine in those distressed communities,” said Michael Kressig, partner in the St. Louis office of Novogradac & Company LLP. “The fuel powering that engine would be operating businesses. … This program will not achieve the envisioned impacts unless we are able to incentivize the investment in operating businesses on a scalable level.”

“The rules around operating businesses are murkier. There are far more questions than answers,” said Steve Glickman, founder and CEO of Develop LLC, who was also a co-founder of EIG. However, Glickman said, “There is a lot of investor interest as well as venture capital and private equity interest [in OZs].”

Questions Surrounding Operating Businesses and the OZ

One of the key benefits of the OZ incentive is that taxpayers holding qualified opportunity fund (QOF) investments for a period of at least 10 years can step up the basis of the investment to fair market value upon disposition, thereby avoiding taxation on the appreciated value.

Ten years is a long time for an investor to hold an investment in an operating business. “That doesn’t line up well for venture capital or private equity investors, who typically hold investments for three to seven years,” said Kressig.

“I think about what we do today and how the OZ forces departures from our traditional model. Our fund duration is five to seven years, which is typical for operating business investment funds,” said Jonathan Goldstein, managing director of Advantage Capital, which is looking into becoming an OZ fund manager. “Now, overlay the OZ. One key benefit of the OZ is the forgiveness of gains if you stay in for 10 years. That’s a longer term than we are used to and requires us to reorient our partners to some extent.”

This 10-plus-year timeline is much more suited to real estate investments, which is one reason real estate investments are taking off before operating business investments. “In terms of asset classes, real estate works better because of the 10-year hold,” said Kressig.

In order to extend fund duration without shifting the risk curve on investments, fund managers hope to revolve investment between assets without diluting program benefits. Potential operating business investors want to know whether gains realized by a QOF for the sale or exchange of OZ property can be deferred if reinvested in replacement OZ property within 12 months of the sale or exchange.

“The statute envisioned this, but it was not addressed in the initial tranche of regulations,” said Kressig. “We need guidance on this issue before most venture capital and private equity funds will be willing to play in the sand box.”

Glickman hopes that clarifications in this matter will be addressed in the second tranche of guidance from Treasury, which is expected as early as the end of 2018.

Until more guidance becomes available, Glickman advises investors and fund managers to assume they have to hold the same investment for 10 years. “That may keep a lot of business investors and fund managers on the sidelines,” said Glickman. “Treasury needs to provide clarity on that to get more investments in funds.”

Qualifying as an OZ Business

Treasury’s new draft guidelines state that at least 50 percent of the gross income of a qualified OZ business must be derived from the active conduct of a trade or business in the qualified OZ.

While this is easy to determine for real estate, it is much harder to determine if an operating business qualifies for the OZ incentive. “This could be problematic,” said Glickman.

Glickman said this is easier to determine for small “mom and pop” businesses. However, Glickman and Goldstein wonder if high-growth businesses with national or international distribution qualify for the OZ. If these fast-growing businesses don’t meet the 50 percent test and don’t qualify for the OZ, then Glickman worries that the job-creation goals for the OZ incentive won’t be met.

“I’d hate to see business investments be narrowed to local businesses,” said Glickman. “[If that happens then] much less capital would flow into operating businesses. The idea that the incentive would be used for many small businesses is just not practical.”

“On the other hand, if there are new investors with skin in the game, it can lead to other positive developments,” said Glickman. “Now, they want to open a restaurant or incubator space.” Glickman said getting scalable businesses to move to these zones is what will really make a difference.

Definitions

Industry participants are looking for clarification on defining certain terms.

Goldstein said it is clearer how to meet the substantial improvement criteria for real estate than it is for operating businesses.

OZ rules require that most of the business’s tangible property be new to both the business and the OZ. That’s a hard test under any circumstances, so the program provides an exception if the business “substantially improves” the property. Substantial improvement occurs if, during the 30-month period after the date of acquisition of the property, additions to the tax basis of the property in the hands of the business exceed the tax basis of the property at the beginning of the 30-month period.

“That’s a well-understood concept in real estate development, but it is not clear what that means for operating businesses,” said Goldstein. “Without the ability to use substantial improvement, companies would have to be quite young or perhaps have little in the way of tangible assets. It would be hard to meet that test for growing an existing manufacturing or food services company.”

Goldstein said, “real estate is a more comfortable fit for the OZ right now. It is a longer-term, stable investment. It is local. … And it is much more obvious to do the substantial improvement test.”

Conclusion

“Very little is happening with operating businesses,” said Kressig. “There are funds out there being formed, planning is going on behind the scenes, but the OZ incentive is not being used yet for operating businesses. … There is just too much uncertainty.”

However, industry practitioners are optimistic.

“I fully expect private equity investments in operating businesses to be a large and very successful sector of the OZ, but it may take a little longer to come to fruition,” said Glickman.

“There is certainly a lot of interest. People are spending a lot of money and time on this incentive,” said Kressig. “It will be robust two years from now.”